On July 8, 2009, Joe and Jill sell their principal residence for $650,000. Their adjusted basis in the property is $275,000. To complete the sale, Joe and Jill have to take back a second mortgage for $120,000. The buyers borrow $465,000 from a local bank and put down $65,000 in cash.
In December 2011, Joe and Jill are notified that the buyers have defaulted on the second mortgage and filed for bankruptcy. A large manufacturing plant near the house has closed, and the housing market is overstocked; the value of the house has dropped significantly—below the amount remaining on the bank’s mortgage. Joe and Jill want to deduct the loss on the second mortgage. The IRS Hot Line adviser tells them the loss is not recognizable because they have no basis in the mortgage debt. Joe and Jill never reported as income the payments they received on the second mortgage. Advise Joe and Jill on the deductibility of the defaulted mortgage.